Bank stocks rebound is something of a mirage

Australian banks appear to have swung back to big profits but the growth story isn’t quite what it seems.

The big banks are back making big profits, or so it seems. ANZ, NAB and Westpac all reported spectacular earnings increases this week, but don’t be fooled, bank stocks are nowhere near the investments they used to be.

It’s undeniable that at first glance the numbers look terrific. Westpac tripled its half year profits compared to a year earlier. At ANZ and NAB the profits for the six months to March 31 nearly doubled. Industry leader CBA reports on a different calendar cycle — it will report full year in August.

But the headline profits were broadly underpinned by writebacks. Put simply, the banks had put aside huge amounts of cash for what looked like a COVID-based financial catastrophe. The catastrophe never came to pass, so they replaced those funds and profits bounced dramatically.

Now if we look at the profits at the bank without those writebacks the results are humdrum. As KPMG banking strategy lead Hessel Verbeek says: “Among the major banks, while the reported pre-tax net profit growth against last year is 46 per cent, after adjustments it is a more modest 1.3 per cent.”

Yep, 1.3 per cent profit growth is definitely more modest than 46 per cent, that’s for sure! Rather than a rebound, it’s routine.

Unfortunately, it is the adjusted number we need to be looking at because it is a reflection of the everyday bank business.

At their best, banks stocks can give you a constantly growing share price and a hefty fully franked dividend. But in this latest batch of results there are strong signs that banks are still nowhere near the level that can underpin that two-stream winning combination.

For a variety of reasons — high labour cost, remediation costs, low interest rates — banks are not as profitable as before. They used to have a return on equity of 15 per cent or more; nowadays it is more likely to be 10 per cent.

Ultimately investors in banks are looking at the dividend picture, which is useful because the long term share price story is woeful. Westpac may have tripled its profits this week but the share price has only just inched back to where it was in 2007.

For income-focused shareholders it’s a bank’s payout ratio that’s the key number. When markets were a little more normal — before official rates were pushed to artificially low levels by central banks — the payout ratio at banks was generally 75-85 per cent. In mid-2021 the dividend payout ratio average is 63 per cent. More important, the three banks reporting this week — ANZ, NAB and Westpac — have all indicated their ongoing target is 65 per cent.

Dividend payout ratios move up slowly and banks need to have less pressing demands on their capital to lift the mount distributed. So NAB ‘‘doubled its dividend’’ in the half year, but that barely brings the payout ratio back to the 65 per cent target.

Even allowing for their dominance of home lending, the banks are not as profitable as they were and they can’t dish out the dividends as they once did.

The major miners

The issue now is how the banks stack up against alternatives. Of course bank dividend yields are better than cash deposits but on the sharemarket they have a new rival: the major miners.

Big miners were rarely seen as reliable dividend payers but in the wake of the COVID crisis, when the banks had to cut or skip dividends the miners stepped up.

Industry analysis of self-managed super fund portfolio activity shows allocation to mining stocks is up while banks are getting less money.

Nabtrade ­director of SMSF and investor ­behaviour Gemma Dale recently explained: “We are clearly seeing older investors moving towards the miners because they have the dividends and franked dividends remain crucial for this group.”

What’s more, the outlook for miners in contrast to the banks remains very strong.

As Verbeek at KPMG says, profit margins and interest margins will continue to be under pressure in the current low interest rate environment, while costs are ‘‘stubbornly high’’.

In fact, the current cost to income ratio of 50 per cent-plus across the board at the major banks is back to where it was more than a decade ago.

At the same time the big miners see commodity price upgrades across the board, from copper to iron ore — and these dividends keep coming.

That’s not to say banks are broken — far from it — they may even do share buybacks if things keep improving.

But they are rebuilding their books and dividends are lower down the scale than balance sheet repair.

Meanwhile, miners are continuing to be very competitive with banks for dividend-hungry investors — forward dividend yields can be twice as high as bank stocks.

Every week we get new upgrades for key commodities such as copper and related metals.

Crucially, iron ore just broke an all-time record price and brokers are busily upgrading their forecast price for the year ahead. Just now iron ore is selling for $US200 a tonne; it is being dug out of the ground for less than $US20 a tonne, so don’t worry — the dividend-paying capacity in mining is extremely comfortable.

Dividend-hunting investors who made the move to switch out some stock in big banks for big miners are already being rewarded, and that looks like being the case for a while yet.